With the year-end fast-approaching, many employers are turning their attention to bonus arrangements for 2011. Latham & Watkins’ attorneys in Germany, France, the UK and the US consider some key concepts and drafting issues applicable to bonus agreements.

1. What are bonuses? How do they differ from commission?

The term “bonus” does not have a prescribed legal meaning, and may be used to refer to a number of different incentive arrangements. There is a distinction in all of the jurisdictions discussed here between a bonus (which often takes the form of a cash payment made in recognition for good performance over a particular period) and commission (which usually refers to an incentive arrangement where employee is paid a percentage of the profit that is earned by his employer as a direct result of his work).

In Germany, the term “commission” has its own legally-defined meaning, and there are rules governing its payment with which employers often fail to comply. These rules do not apply to bonuses.

In France, in addition to bonuses and commission (neither of which are defined in French law), employers are encouraged, and sometimes bound, to offer collective profit-sharing schemes to their employees. Unlike regular bonuses and commission, these schemes are exempt from social security contributions.

2. What is the degree of employer discretion permitted in bonus plans or arrangements?

As stated above, bonuses are usually performance-related, but employers often provide for at least an element of discretion in the value of bonus payments. For instance, an employee may have qualitative bonus objectives — to improve client relationships, for example — as well as quantitative ones, such as ensuring turnover exceeds a set target during the performance period. In a number of jurisdictions, case law and regulations have developed to restrain the level of employer discretion in these circumstances.

In Germany, the purpose of a bonus affects the degree of an employer’s flexibility and the extent to which the German labor courts will interfere with an employer’s assessment of the bonus award. In particular, performance-related bonuses are regarded as an essential element of remuneration, and there are strict rules derived from case law concerning them.

In France, employers traditionally have enjoyed wide discretion as to whether to pay occasional bonuses, to determine the amount and to select who will be eligible for bonuses. The ambit of that discretion has since been reduced by terms in employment contracts, collective bargaining agreements and employer initiated bonus plans. When a bonus is paid pursuant to a plan, it must be paid pursuant to the plan’s terms and conditions, which must be objective and precise.

Moreover, according to recent French case law, each employee must be able to verify that the calculation of their bonus is compliant with the terms and conditions of the bonus plan, and so must be provided with the bonus calculation formula and details of any individual or group performance targets. If this is not provided, then the conditions will not be enforceable, and 100 percent of the target bonus will be payable.  

In the UK, a bonus may be described as being entirely discretionary, in which case an employee will have difficulty proving a contractual right to the bonus. In practice, however, bonus plans are often only partly discretionary, allowing employees to dispute the way in which an employer’s discretion is exercised. For example, if an employer has expressly reserved an element of discretion in the UK and Germany, when determining if performance targets have been met or the value of bonus that a particular level of performance will trigger, that discretion must exercised in good faith, and not in a manner that is perverse or irrational. The UK courts may award damages to an employee for the amount that the court considers likely to be payable on the fair and rational exercise of discretion, however, there is no requirement for the exercise of the employer’s discretion to be “reasonable,” and the English courts are generally reluctant to substitute their judgment for that of the employer.

In the US, an employer can design a bonus to be entirely discretionary, with or without specific performance conditions set out in the bonus award and if so, an employee generally will not have a contractual right to receive it. However, if a bonus is guaranteed upon achievement of certain criteria, the employee may have a contractual right to it if the terms of the award are fulfilled. State wage and hour laws may also apply in determining whether a bonus has been earned and must be paid, in whole or as a pro-rated basis.

In France, the US and the UK, custom and practice may limit the ambit of an employer’s apparent discretion as to how performance achievement is measured. If an employer has consistently used a particular method to assess performance over a number of bonus cycles, and with does not reserve discretion to do otherwise, then its employees may argue that they have an implied right to have their performance measured in that way. In Germany, if an employer has paid a discretionary bonus without reserving sufficient right not to, then the employees may argue that they have an implied right to be paid a bonus in the future.

3. Can an employer clawback or cancel a bonus?

In Germany, performance-related bonuses may be cancelled if: (a) there is specific language entitling the employer to do so in the contract or bonus plan, (b) the employer’s cancellation right concerns no more than 30 percent of the total remuneration value, and (c) the exercise of the right of cancellation is lawful and fair in all other respects. It is therefore difficult for employers in Germany to enforce a cancellation right. Though discretionary bonuses can be subject to clawback in certain circumstances, there has been no case law to provide guidance on whether even performance-related bonuses may be clawed back.

In the UK and the US, as set out in previous edition of The Working World, and in France, including language in a bonus plan or clause of an employment contract which purports to entitle the employer to “clawback” or reclaim some or all of a bonus in specified circumstances is controversial, and the enforceability of such a clause may be challenged by employees on a number of grounds. In the UK and in France, these include challenges on the basis that the clawback provision may be an unenforceable penalty or an unreasonable restraint of trade. In the US, such a clause may be challenged on the basis that a clawback provision is an unenforceable recoupment of wages under certain state laws. Additionally, in the US, the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (see Article on page 11) may cause a company that fails to adopt a clawback policy providing for the recovery of incentive compensation from executive officers in the event of an accounting restatement due to the company’s material noncompliance with financial reporting requirements to be prohibited from listing the company’s securities on a national securities exchange in the US.

4. What is the impact of garden leave on an employee’s bonus entitlement?

In Germany and France, where an employer puts an employee on garden leave during the employee’s termination notice period, the employee is entitled to the same amount of bonus as if he had worked during his notice period.  

In the UK, this depends on the drafting of the bonus and garden leave provisions in the employee’s contract of employment. A well-drafted contract will make it clear that an employee will not be eligible for a bonus if he is under notice on the bonus payment date. Alternatively, if an employee is entitled to a pro-rated bonus, such as when employment terminates part way through the bonus year, the garden leave clause should specify that while the employee is on garden leave, he will not accrue service for that bonus.

In the US, garden leave is rarely imposed upon an employee and instead, employers tend to rely on non-competition covenants in the employment contract (although in recent times the use of garden leave by employers has increased, and generally upon similar terms to the UK).

5. What is the impact of the termination of the employee’s employment on his bonus entitlement?

In Germany, employers were historically only permitted to pro-rate a bonus if an employee’s employment was terminated before the end of the bonus performance period. However, recent developments suggest that German employers may be able to stipulate in the bonus plan that the entire bonus will be forfeited if the employee is not employed for the entire performance period.

In the UK, the US and France, ideally the bonus clause or plan will specify that a bonus will only be payable if the employee is currently employed and has not given or received notice to terminate their employment on the bonus payment date, or alternatively that a pro-rated bonus is payable in these circumstances. In France, however, even with provision for non-payment/pro-rated payment of a bonus, an employee would be able to claim back the bonus if the termination is without cause.

In the UK, if this is not provided for clearly in the bonus provision, an employee may argue that he is entitled to receive a bonus equivalent to what he would have been paid if his employment had not been terminated by the employer part way through the bonus year.

In France, particular attention must be paid to the statutory prohibition on the implementation of “monetary sanctions” on employees.

6. How do equal treatment principles impact on bonuses?

German, French, the US and the UK labor laws apply the principle of equal treatment, with the result that the different treatment of comparable employees is prohibited unless it can be objectively justified. In these jurisdictions, as with all employment-related pay and benefits, bonuses should not be awarded, designed or applied in such a way that could be discriminatory on the grounds of sex, race, disability, sexual orientation, religion or belief, or age. In particular, care should be taken when determining bonus eligibility for employees who have been absent for part of the bonus year due to maternity leave as the risk of a sex discrimination claim in relation to this is high. In addition, employers should be careful of inadvertently discriminating against fixed term and part-time workers when designing and implementing bonus plans.

7. Are there any rights of unions or employee representatives with respect to bonuses or bonus schemes?

In Germany, many collective bargaining agreements provide for the payment of Christmas and vacation allowances, and some also provide for performance-related allowances (particularly in the manufacturing and piece-work sectors). Otherwise, performance-related bonuses are normally granted on company level, which is, without the works council’s co-determination right (if there is a works council), only possible where there is no bargaining agreement which covers, or typically covers, this.

A works council’s co-determination right may be relevant where a bonus arrangement applies to more than one employee, particularly in relation to the introduction or modification of such arrangements. This co-determination right applies to, among other things, performance assessment standards and their application, and the distribution of a fixed bonus pool among a number of employees. Any agreement between the employer and the works council must be recorded in writing, and if they cannot reach agreement, the matter must be referred to the reconciliation board whose decision will be binding. An employer must allow time for bargaining on bonus arrangements, which may take a number of months. It is common practice for both the employer and the works council to have legal counsel throughout this process, and an employer would be well-advised to do so.

In the UK and the US, unless a collective agreement specifically states that it governs the terms of a group of employees’ bonuses, bonus rights are simply contractual between the employee and the employer. In the UK, it is generally more common in the public sector to find collective bonus agreements than in the private sector.

In France, the works council may need to be informed and consulted before collective remuneration schemes or structures are implemented or substantially modified. In addition, companies with trade union representation must conduct annual negotiations on remuneration, including bonuses, with those unions, during which time an employer is prohibited from making any unilateral decisions that would impact collective terms of remuneration, such as bonus plans.

8. How are bonuses regulated in these jurisdictions?

In Germany, while there are strict legal obligations regarding when an employee becomes entitled to a bonus and limiting an employer’s discretion in relation to adjusting performance targets, there are no legal requirements capping the value of bonus payments. Pursuant to the 2009 German Act on Board Member Remuneration, the remuneration of a board member must be “appropriate,” not only in relation to the company’s performance and sector, but also with regard the board member’s individual performance.

In the UK, there are broadly two forms of employee whose bonus arrangements are subject to regulation: (i) board directors and (ii) employees of financial institutions whose activities influence the risk profile of those institutions.  

In the first case, there are a number of disclosure and reporting obligations set out in the Companies Act 2006, the Listing Rules (applicable to companies listed on the Main Market of the London Stock Exchange) and the Combined Code (a code of good corporate governance practice). The more stringent obligations apply to companies listed on the Main Market, including that they are required to explain, in their annual report and accounts, the extent to which their remuneration practices comply with the Combined Code, and to explain any non-compliance. The Combined Code requires that executive remuneration must be sufficient to attract, retain and motivate the executives but that companies should not pay more than is necessary. Furthermore, a significant proportion of the directors’ pay must link individual and company performance to reward, and be “designed to enhance shareholder value.”

As for the second group of employees, the UK Financial Services Authority’s Remuneration Code applies to the largest banks, building societies and broker-dealers in the UK (currently 26 entities) and requires that their remuneration policies be consistent with effective risk management. This is both a rules and a principles-based code, and it applies to the remuneration of employees who perform significant influence functions and whose professional activities could have a material impact on the company’s risk profile. Draft revisions to this code are currently being considered, and these could significantly expand its scope and application. For example, the new proposals include rules on deferring 40 percent of bonus payments, with that percentage increasing to 60 percent for bonuses of £500,000 or more.

In the US, bonuses may be subject to a number of rules, including rules that affect the employer’s ability to deduct bonuses for tax purposes and the timing of bonus payments.

Section 162(m) of the US Internal Revenue Code generally imposes a US $1 million limit on a publicly-traded corporation’s tax deduction for compensation paid or accrued for each of the corporation’s “covered employees,” which include the corporation’s “principal executive officer” and the three most highly-compensated executive officers (other than the principal financial officer). This limit does not apply to “qualified performancebased compensation,” which, in the case of a bonus, means that the bonus is payable solely upon the attainment of performance goals and meets certain other requirements under Section 162(m). If, however, the facts and circumstances indicate that an executive would have received all or part of the bonus regardless of whether the performance goals are attained, the bonus will fail to be qualified performance-based compensation.  

Under the recently enacted Patient Protection and Affordable Care Act, bonuses payable to officers, directors and employees of certain health insurers may be subject to additional deduction limits under Section 162(m).

As discussed in the January 2009 edition, additional compensation standards, disclosure requirements and deduction limits apply to bonuses payable to certain executives of financial institutions participating in Troubled Assets Relief Program.

As considered in the June 2009 edition, Section 409A of the US Internal Revenue Code imposes rules relating to when deferred compensation, which may include bonuses that are earned and vested in one year but payable in a following year, is paid. Deferred compensation that fails to comply with Section 409A generally is subject to US federal income taxation at the time the compensation vests, including an additional tax. Many bonuses are structured to be paid in a manner that satisfies the “short-term deferral” exemption under Section 409A, so that compensation will not be treated as deferred compensation so long as it is paid on or before the 15th day of the third month of the year following the year in which the employee’s right to the compensation vests.

State wage and hour laws may impose additional requirements on the payment of bonuses.

In France, the amounts payable under bonus plans are not usually capped, though there are some industry specific regulations. As in the UK, risk management obligations pertaining to remuneration policies have been imposed on banks and financial institutions pursuant to an order of the French Ministry of November 3, 2009.

9. How should bonus provisions be drafted?

In Germany and France, bonus arrangements are normally set out in the employment contract or in a rider to that agreement. In Germany, bonuses are afforded the protections which the law accords to all employee remuneration, including the assumption that they should be drafted precisely and clearly, and a failure to do so will mean ambiguities are interpreted in the employee’s favor. In France, documents relating to bonus arrangements should generally be drafted in French or a French version should be provided.

In the US and the UK, the content of the bonus clause is more important than its location. However, prudent employers include only minimal bonus provisions in an employment contract — for example, a clause stating that the employee may be eligible for an annual bonus at the board’s discretion. Any specific terms such as performance targets or maximum/minimum bonus amounts could then be set out in a separate bonus plan updated annually to give the employer more flexibility over the terms of the bonus entitlement from year-to-year, and prevents the need for employee consent to revise the terms of the employment contract.

As a general rule, the less specific the provision, the less likely it is to create a contractually binding obligation on the employer to pay a bonus to the employee. However, if a bonus provision is too vaguely drafted it may not be sufficient incentive for employees.

Latham & Watkins’ attorneys Jane Ng in Hong Kong, and Yoko Takagi and Javier García Cueto in Spain, share observations below on the legal regimes concerning bonuses in their jurisdictions:

In Hong Kong, employees are not legally entitled to a bonus unless it is specifically provided for in the employment contract. However, it is common for Hong Kong employers to provide for an “end of year” payment to employees — sometimes referred to as a “13th month payment” or “double payment” — which is often paid around Chinese New Year. Employers are free not to provide for an “end of year” payment, but if they do, then the Employment Ordinance regulates the amount and timing of that payment. When employment terminates, the employee is entitled to the “end of year” payment on a pro-rated basis.

In Spain, there is no specific regulation of bonus schemes, which gives welcome flexibility to employers. The key points are:

  • Bonuses may be set out in employment policies, collective bargaining agreements and/ or individual employment contracts.  
  • Spanish law prohibits discrimination on the basis of sex, race, disability, sexual orientation, religion or belief, or age. Employers are therefore well-advised to use clear, objective bonus targets, and to avoid using bonus arrangements that depend entirely on their discretion.  
  • Where a bonus arrangement provides for an employer to determine applicable performance targets, an employee will not be entitled to the target bonus if he disputes the fairness of the bonus objectives. However, if his employer fails to set the bonus criteria or the target bonus value, the employee is entitled to receive the bonus, and the Spanish court will determine the appropriate amount.  
  • A bonus forms part of an employee’s “salary” for both labor law and social security purposes, and so must be taken into account in the calculation of severance payments unless the employee leaves voluntarily or was fairly dismissed before the bonus accrual period ended.  
  • Spanish practice allows for complex remuneration schemes in which a bonus may be linked to other incentives. Such schemes are common in management buyouts, where bonuses may be combined with debt and equity-linked participation programs, sometimes based on envy ratios or ratchets (otherwise known as “sweet equity”, whereby management have a right to purchase equity at a discount so as to encourage them to improve the value of the equity on exit).